THE UK FINANCIAL SECTOR, REGULATION AND THE

FINANCIAL CRISIS

E Philip Davis

NIESR and Brunel University

West London

e_philip_davis@msn.com

www.ephilipdavis.com

groups.yahoo.com/group/financial_stability

Course on Financial Instability at the Estonian Central Bank,9-11 December 2009 – Lecture 5

Overview

• What is a bank – how do they fail?• The role and nature of financial regulation• How did the financial crisis impact on the

UK?• The safety net – issues for the UK• Prudential regulation• Cross border aspects• Some comments on the Turner Review

• Traditional bank

What is a bank – why do they fail?

Assets Liabilities

Capital Liquid assets

Illiquid loans

Retail deposits

• “Modern” bank

Assets Liabilities

Liquid assets Capital

Illiquid loans Retail deposits

Illiquid securities Wholesale deposits

Loans being securitised Illiquid securities

Illiquid securities in SIV/conduit Asset backed commercial paper with bank back up line of credit

The role and nature of financial regulation

• Aims to protect against market failures– Information asymmetry– Externality– Monopoly

• Two aspects of regulation– The safety net – lender of last resort and deposit

insurance - ultimately recapitalisation/nationalisation – “the current issue”

– Prudential supervision – capital adequacy and supervisory monitoring – and macroprudential analysis – “the future issues”

UK regulatory framework

• Tripartite system of Treasury, FSA, Bank of England– Financial Services Authority (FSA) is responsible for

financial and banking regulation;

– Bank of England contributes to the stability of the system through monetary policy, its lender of last resort operations and macroprudential surveillance;

– Treasury is responsible for the overall architecture of the system and aspects affecting the public finances

Size of UK banking sectorPanel A. Resident banking–sector assets (multiples of GDP)

Country 2007 2008

UK 5.0 5.5

Euro area 3.3 3.5

US 0.9 1.0

Panel B. UK resident banking–sector assets by currency (multiples of GDP)

Bank ownership £ assets Foreign currency assets

Total assets

UK 1.40 1.05 2.45

Other European Union 0.47 1.05 1.51

American 0.08 0.44 0.52

Japanese 0.01 0.11 0.12

Other developed 0.16 0.65 0.81

Other 0.01 0.05 0.06

Memo: building societies 0.26 0.02 0.27

FSIs for UK banks

2003 2004 2005 2006 2007 20081

Major banks tier 1 capital ratios – median 8.1 8.0 7.9 8.0 7.7 7.9

Bank capital to assets – median 26.7 26.6 30.4 30.8 31.2 34.1

Bank non-performing loans to total loans 2.5 1.9 1.0 0.9 0.9

Bank provisions to non-performing loans 69.8 61.5 54.0 54.6

Bank return on assets 0.6 0.7 0.8 0.5 0.4

Bank return on equity 8.6 10.9 11.8 8.9 6.2

Customer funding gap

Major elements of UK crisis• Freezing of interbank markets from August 2007 requiring

liquidity assistance by Bank of England• Retail and wholesale customer run on Northern Rock, failed

in September 2007• Bradford and Bingley, Alliance and Leicester had to be

taken over• Need to nationalise and recapitalise RBS and HBOS with

massive, partly covert, state assistance in October 2008• UK bank losses estimated at £36 bn in October 2008,

initially mainly US securities, later UK defaults. Many losses from poorly capitalised subsidiaries (SIVs and conduits) whose size “surprised” regulators

• Serious collapse of real economy ensued

Northern Rock – failure of supervision• Asset risk - made up to 125% mortgages, and liability risk –

high dependence on wholesale funding• Longest regulatory periods between formal ARROW

assessments (36 months) and lowest number of close and continuous regular surveillance meetings, only high impact firm without a Risk Mitigation Programme

• Moved between FSA divisions three times in as many years – and division mainly responsible for Northern Rock had suffered staff cuts

• Records of supervisory meetings were often not kept• In Spring 2007 allowed to pay a large dividend and reduce

its capital adequacy target, although FSA already concerned about liquidity

Lessons for the safety net

• Huge cost of recapitalisation– Major burden on fiscal policy, to add to cyclical swing

– How realistic to expect 2007 maintained?

– Keeping public support for recapitalisation

– The poor performance of public banks

• Deposit insurance shown to be inadequate– Increase in limits to £50,000 and 100%

– Ability to access in 7 days

– Should the system be prefunded?

– Should there be risk based premia?

• Lender of last resort overburdened– Successful covert lending to HBOS and RBS after

failure with Northern Rock

– How to exit from the high level of liquidity support?

– Is “stigma” adequately dealt with?

• Special resolution regime instituted– Banks can be put into resolution when not technically

insolvent, in interests of financial stability

– A step forward from Northern Rock….

– ….but need for numerical prompt correction action targets (link to capital and liquidity) to avoid forbearance

– Could Bank of England be overburdened?

Lessons for prudential regulation• Capital adequacy failed to prevent crisis

– The FSA’s trigger ratio system is helpful – but should targets be published (also ARROW, liquidity)?

– Banks should be required to hold adequate capital for off–balance sheet risks, so as to counter regulatory arbitrage and reputational risks. Accounting treatment of off–balance sheet assets should be aligned with the underlying risks.

– Higher capital across the board (banking and trading books)?• Raises the cost of intermediation

• But reduces incidence of financial instability

– Capital adequacy and procyclicality• Spanish approach conflicts with accounting rules…

• ….but other are just theoretical

• Leverage ratio warrants consideration (NIESR work shows effect on crisis probability)

• Liquidity regulation had been forgotten– The new UK proposals – a marked advance given

narrow liquidity had fallen to 1%…likely to raise government bonds from 5% to 10% of assets

– …but how compatible with maintaining the City as a financial centre

– Need for an aggregate quantitative target?– Equal attention to liability management?

• Other prudential regulation had let banks take unwarranted risks– Limits on LTVs needed for mortgages and commercial

property– Ensuring remuneration covers the lifetime of products– Is there a need to divide commercial and investment

banking again? Reduce bank size?– Caution in government guaranteeing securitisations– Regulation of innovations needed – like drugs?

• Macroprudential analysis had failed to provide effective warnings– How to act if macroprudential warnings are given –

speeches or action?

– Ensuring macroprudential considerations enter the ARROW process – and individual supervision

• Did the UK’s “light touch” fail?– Specific issues with Northern Rock

– General issues allowing risky lending, wholesale funding, inadequate assessment of takeovers

• Structure of regulation – more dual key to avoid underlap

• Or even moving LCFIs back to the Bank?

Cross border aspects• How far ahead can the UK go alone – does the

“City” concern dilute desirable regulation?• Problems of Basel 2 – back to the drawing board?

– Rating agencies– Risk models

• Why no global agreement on liquidity?• Learning from Iceland – institutions that are “too

big to save”, branching and cross border LOLR• Icelandic bank deposits unprotected – use of anti-

terror law to seize assets• Broader cross border issues of home/host

unresolved – coming at express speed in Eastern Europe……

Some comments on the Turner Review….

• Long run solutions not current issues• Very negative on market discipline – but do the

regulators really know best?• The boundary problem – how easy to regulate the

unregulated?• Institutional co-operation or conflict in macroprudential

surveillance?• New EU regulator – but what role?• Desire for cross border operations as self capitalised

subsidiaries - major challenge to the current passporting procedure.

…and the possible downgrading of the FSA

• Does the Bank of England want to regulate banks – what are the costs?

• What is the middle ground – can the Bank have macroprudential levers?

• What sort of institution will the FSA be as a “consumer protection” regulator?

• Could there be dangers in the transition?

References

• Davis E P (2009), “Banking on prudence”, chapter of OECD Report on the UK Economy, OECD Economics Department Working Paper